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ANTITRUSTLAWJOURNALEVALUATING VERTICAL MERGERS:

A FOST-CHICAGO APPROACHMICHAEL H. RIORLWN

STEVEN c. SALOP


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EVALUATING VERTICAL MERGERS:A POST-CHICAGO APPROACHMICHAEL H. RIORDAN

STEVEN C. SALop*I. INTRODUCTION

Antitrust law governsboth horizon tal and vertical agreements.Theseagreements ncludejoint pricing, exclusivityarrangements, nd mergers.In evaluating horizontal a greements, here is general consensushowsuch agreementscan facilitate collusive pricing. The proper antitrusttreatment of vertical agreements s far more controversial. n this area.there s no consensus bout whetherand how anticompetitive effectscanoccur. There is p erhaps no better example than in the area of verticalprice agreements,where on e prominent commentator has called forreplacing per se llegality w ith per se egality.

The antitrust treatment of verticalmergersalsohasbeenhighly contro-versial.Antitrust treatment of vertical mergerswasextremely restrictivein suchcases sBrownS/up and Ford-Auk&. However, strong criticismof thosecases y Chicago Schoolcommentatorsand others led to a newperspective n which vertical mergerswere viewedasgenerally competi-tively neutral or procompetitive.l The awhorr are, crpectively,rofessor of F.conomio.oston niversitynd Profa-sor f Economicsnd Law,GeorgetownniversityawCenler. e ould l ike 10 acknowl-cdGil!&, Whelpful comme nts from Douglas Bernheim. Ronald Bond, Lephen Calkim. Richardarren Grimes, James Key% Thomas K rstrenmsker. Tina Mil ler, M au Reil ly,Gary R&ens, and R&n Wil l ig. A previous version of rhea srr icle was presented a1Ihe FTC/DO J/ABA/GU LC Conference, Post-Chicago Economics: New Theories-NewCases?. Washington. DC.. May 26-27, 1994. Richard A:Posner, Tk Nat Sup in lix Anfihur Tmdmml of Rdided Dbhduliat: Pn

St Lepdity, 40 U. Cm. L. Rw. 6 (1981). k&n Shoe Co. V. United Suws. 370 US. 294 (1962).Ford Motor Ca. V. United Slaves. 286 F. Supp. 407 (E.D. Mich. 1968). n/Td, 405 U.S.

562 (1972).Se t Rosxw H . Bow . . THE ANTITRUSTA~WX 225 (1978); Robert H. Bork CI al. .

The Cc& of Ati l i tnul: A Did&w on Polity, 65 COLUM. L. Rnv. 369 (1965); Tho mas G.Krattenmaker & Steven C. Salop, Anlicmmptt ivr Exclwim: Raising Rids Cor(r lo AchimePow. Over PG. 96 YAU LJ. 209 (1966).


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514 ANTITRUST LAW JOURNAL [Vol. 63This more benign view formed the foundation of the 1984 Departmentof Justice Merger Guidelines and 1985 Vertical Restraints Guidelines.It also led to a highly permissive vertica l restraints policy during theReagan and Bush Administrations , apart from the AT&T divestiture ,For example, the Department of Justice (DOJ) under the Reagan andBush Antitrust Divis ions prevented only a single vertica l merger, the

proposed combination of Showtime and The Movie Channel with anumber of film distributors.During the same period, the Federal TradeCommission (FTC) brought one vertica l merger action-the Goodrich-Diamond Shamrock proposed merger. But both these mergers hadimportant horizontal as well as vertical merger elements.

This record on vertica l integration has come under recent attack. Forexample, Congressman Jack Brooks stated:It is not that vertical integration of production and distribution automat-ical ly poses a competitive threat of foreclosure and barriers to entry tonew entrants; it may not. The difficult y faced is hat vertical mergers, forthe past 12 years. weredeemed barely worthy of any careful competitivescrutiny at all by the antitrust enforcement agencies. This was a gross

abdication of responsibil ity, and I know that such a cavalier approachwont be repeated with the current leadership at the Justice Departmentand FTC.O

Attitudes like this have led to increased enforcement efforts againstvertica l integration. One of Assistant Attorney General Bingamans firstofficial acts was to repeal the Vertica l Restraints Guidelines. The DOJrecently issued a complaint (and settled) a vertica l tying-exc lusive dealingcase against Electr onic Payment Systems, the owner of the MAC ATMnetwork. It also obtained a consent decree in the TCI-Liberty recombina-tion.r The DOJ and the Federal Communications Commission (FCC)

U.S. Department of Justice Merger Guidelines (1964). reprinted in 4 Trade Reg. Rep.(CCH) ( 18.109. at 20,564 [hereinaft er 1964 DOJ Merger Guidelines].

U.S. Department of Justice Vertical Restraints Guidelines (1965). reprinted in 4 TradeReg. Rep. (CCH) (I 19.105. at 20,577 [hereinafter 1965 DOJ Vertical RcltraintlGuid clinea].These Guidelines were reminded by the Clinton Administration in 1998.

United States v. AT&T Co.. 552 F. Supp. 191 (D.D.C. 1962). #dssub nom. Marylandv. United States, 460 U.S. (1988).

See Lawrence J. White. Antihut and Vi&o Mark&: The Merger of Showtim and TheMovie Channel ar a Cart Study. in VIDEO MEDI A COMPETITION : Rrcuuwm. Eco~omtcs ANDT~CHNOLOCV 986 (Eli M. Noam cd., 1965).

* B.F. Gwdrich Co., I IO F.T.C. 207 (1966). Letter from Congressman Jack Brwks. Chairman of the House Judiciary Commit tee,

to DOJ Assistant Attorney Gcnrral Anne Bingaman and FTC Chairman Janet Steigcr(Nov. 4. 1998).

United States v. Electronic Payment Sys.. Inc.. Civ. No. 94-206 (D. Del. Apr. 21. 1994)(complaint); 59 Fed. Reg. 44.757 (Aug. 80. 1994).

I9 United States v. Telc-Communica tions. Inc.. 59 Fed. Reg. 24.729 (May 12. 1994). TheFTC aim obtained a consent dccrer with TCI in the potentia l vertical acquisit ion of

19951 EVALUATING VERTICAL MERGERS 515investigated the acquisition of McCaw Communications by AT&T andthe DOJ obtained a conduct-oriented consent decree.r In response toa Congressional mandate, the FCC simi larly is engaged in extensiverulemaking to govern vertica l integration in the cable televisionbusiness.

This renewed concern also reflects the current view among economis tsthat vertica l mergers can lead to anticompetitive effects under certaincircumstances. The Chicago School critique of vertica l merger policy hasprecipitated a more refined analys is of vertica l mergers. These new post-Chicago theories neither ignore nor reject the economic analysis of theChicago School. Instead, they apply the newer methodology of modernindustrial organization theory to more realis tic market structures inwhich vertical mergers can have anticompetitive effects. Although thisscholarshio certainlv does not suggest a return to the Brown S/we view:-of vertica l mergers: it does identtfy situations where vertical mergersand other vertical restraints can raise significant competitive concerns.Paramount by QVC, an entity in which TCI has a partial ownership interest. Telc-Commu-nications, Inc., 58 Fed. Reg. 68.167 (Nov. 90. 1999). The ccmwnt decree was withdrawnwhen QVC failed in its bid to purchase Paramount .

United States V, AT&T, 59 Fed. Reg. 44.156 (Aug. 26. 1994). In addition. Bell Atlanticand Nynex wed in district court to block the acquisition. That case ultimate ly settled beforetrial.

The Cable Television Consumer Protccdon and Compet ition Act of 1992. Pub. L. No.102.865, 106 Stat. 1460 (1992): First Report and Order in the Matter of Implem entation ofSections 12 and 19 of the Cable Television and Consumer Protection Act: Dcvelupmentof Competition and Diversity in Vidcn Programming Distribution and Carriage. MMDocket No. 92.165. released Apr. 1. 1992; Report and Order and Further Notice ofProposed R&making in the Matter of Implemcntatiun al Sections I I and I8 of the CableTelevision and Consumer Protection Act: Horizontal and Vertical Ownership Limits. Croas-Ownership Limitatio ns and Anti-Traficking Provisions, MM Docket No. 92-264. rclcased

July 28, 1998; Second Repart and Order in the Matter al lmplcmen ration of Sections I Iand 18 of the Cable Television and Consumer Protection Act: Horizontal and VerticalOwnership Limits, MM Dacket N o. 92-264. released Oct. 22. 1999.) There is now an extensive literature in cctmOmic$ and law analyzing the comperiliveconcerns raised by vertical mergers that goes back at least to JOE S. BAIN. BARR IERS TONEW COMPETITION 1-41 (1956). For a sampling of recent arlicb% see Krattcnmaker &Salop. rupm note 4: Janus2 A. Ordover et al.. Nonp!in Anticomptli l ivr Behavior qV DominantFirm TownrdlhcPmducnso,ConplnmrorlPraducls. m ANTITRUST AND REGULATION: ESSAYSIN MEMORYOPJOHNJ. McCow.w I15-190 (Franklin Fishercd.. 1965): Michael A. Salingcr.VetiicalMergrr~ ondh4arkrrFwrrlorurr. 77 Q.J. Ecotv. 845 (19RS): Oliver Hart &Jean Tirolc.Vtrtical h&-r&m ad Mark! Fornlosurr. Baooa~~~s PAPE RS ON ECONOMIC ACTIV ITY 205(1990); Louis Kaplow , Extmrion o/ Mon@ly, Powrr Through Ltucragr. 85 COLUM. L. REV.515 (1985); Janus2 A. Ordaver CL al.. Equilib nun VmtvalFonclosure. RO Am. ECON. Rrv. 127(1990) [her&after Ordover. Eq uilibnun ]; David Rciffen. Equilib rium Verfic al Forerlmurr:Cantnt. 62 Au. ECON. REV. 694 (1992): Janusz A. Ordovcr et al.. Equili btiun VerlirolForcclorurr: &ply, 82 Au. ECON. REV. 69X (1992) [hereinafte r Ordover. Heply]; Eric B.Rasmussen et al. N&d Exclwion, 81 Aoc. ECON. Rrv. ,187 (1991): Jeffrey Church &Neil Gandal, Equilibrium Foreclosure and Cnmplement ary Praducts (Sackler Lnrtitutc OfEconomics, Tel-Aviv University Working Paper No. 8-99 March 19YS). For recent surveysof the ccwwxGs literature, sec. e.g.. Martin K. Perry. Vrrfiral Inlegralion: Delrnnmanlr and


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516 ANTITRUST LAW JOURNAL [Vol. 63Given these new attitudes toward vertical mergers among pol icy mak-ers and economists, it is appropriate to dist ill the latest economic learning.This article is a step in that direction. We explain how vertical mergers

can lead to anticompetitive effects and identify a number of factors thataffect the likelihood and magnitude of those effects. We also discuss theefficiency benefits of vertica l mergers and how the net competitive impactcan be evaluated.Part II of the article se ts out the Chicago School critique of 196Os-style vertical merger law and explains how a theory of anticompetitivevertical mergers is consistent with modern microeconomics. Part IIIdiscus ses the efficiency benefits of vertical mergers and a general method-ology for balancing efficiency benefits against anticompetitive harms.Parts IV through VI discuss three categories of anticompetitive concernsfrom vertical mergers: input and customer foreclosure, information ex-change, and evasion of regulation.

II. THE POST-CHICAGO ANALYSIS OF VERTICAL MERGERSThe permissive policy toward vertical mergers, derived from the Chi-cago School, is premised on a simple economic model. In contrast, thepost-Chicago approach relies on more reali stic and complex economic

analys is that facilita tes the identification of anticompetitive concerns thathave less importance in the Chicago School approach.A. THE CHICAGO SCHOOL CRITIQUE OF 1960s VERTICAL ME RGER LAW

The Chicago School critique of Brown Shoe and other antitrust chal-lenges to vertical mergers is based on two main tenets. First, the merefact that a vertical merger forecloses rival firms access to the supply ofinputs produced by one input supplier does not mean that the net supplyof inputs available to those rival firms has been reduced. When the riva lslose access to the input supplies produced by one firm, they are likelyto gain access to the input suppliers that previous ly supplied the mergingsuppliers downstream merger partner. In that case, according to Chi-cago School theory, the vertical merger does not reduce the net supplyavailable to rivals. Instead, it merely realigns purchase patterns amongcompeting firms.Effecti, in I HANDEZWK or INDUSTRIAL ORGANIZATION 189 (Richard Schmalensee & RobertWillig eds.. 1989); Michae l L. Katz. Vcrltiol ConlrorrulR~kzdom , in I H~~osoon or INDUS-IXIAI. ORGANIZATION 655 (Richard Schmalens ee & Robert Willigeds.. 1989); and the manyaniclescired therein. For analyses by andtrust lawyers sc hwlcd in economics. we 3 PHILLI PAarso~ & Do~~~oTurow, . AN.~IT.U ST LAW ,, 736 (1978); H~,,sr,rr HOYEN KAMP. FEE,,A,.ANTIRUST POLICY: THE LAW OF CMPETI.IIN AN ITS PRAC~CL 285-89. 929-49 (lYY4).

As Bork points out. the cure for such naive allegat ions of foreclosure could be %nindustry social mixer* to facilitate the realignm ent. Boar. supra note 4. at 232.

I9951 EVALUATING VERTICAL MERGERS 517Second, the Chicago School utiliz es an oversimpl ified microeconomic

model to conclude that vertical mergers carried out by a monopolistcalln ~jt enhance monopoly power. The idea is that there is only a singlemonopoly profit that can be earned be the monopolist, whether or notthe monopolist is verti cally integrated. Instead of enhancing monopolypower, the only economic motive for vertical merger is to reduce costsby achieving synergies.

Post-Chicago industria l organization economics accep ts, as a startingpoint, these criti cism s of pre-Chicago foreclosure theory. However, ithas extended the economic models to more real istic assumptions thatreach a more refined understanding of foreclosure. The modern indus-trial organization literature has formulated models of vertical integrationin which vertica l mergers lead to real foreclosure in which the net supplyof inputs available to riva ls is decreased. Models have been formulatedin which monopoly power may be created or enhanced-and monopolyprofits thereby increased-by vertica l mergers that have little or no efti-ciency benefits. In these post-Chicago models, some vertical mergers canbe anticompetitive, although others are procompetitive.Post-Chicago analys is also relaxes the restric tive assumptions uponwhich the single monopoly profit theory is based. In particular, the singlemonopoly profit theory re lies on the following four assumptions: I8

(1) there is a monopoly input supplier, whose monopoly is protectedby prohibitive barriers to entry;

(2) the monopoly is unregulated;(3) there is perfect competition in the downstream output market; and(4) the technology for producing output involves usage of all inputs

in fixed proportions.In the absence of these four assumptions, the single monopoly profitresult no longer holds. Instead, vertica l mergers may be motivated byeither monopoly power, economic effi ciency concerns, or both.

When the input market is not a monopoly, the analys is of vertica lmergers is altered. Vertical mergers in these circumstances can haveanticompetitive or procompetitive effects through a number of mecha-nisms. A vertica l merger can create barriers to entry or expansion byforeclosing or disadvantaging unintegrated rivals. A vertica l merger also~_-

Id. II 229.II An analogous version would center the monopoly in the output market and pcrfcrtcompet ition in the inp market. Relaxing those assumprions alters the results analogouslyto Ihc rcsulu discussed in Ihc text Lxlow.


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518 ANTITRUST LAW JOURNAL [Vol. 63can facilitate tacit or express pricing coordination among the competinginput suppliers. In either case, a vertical merger may lead to a reductionin net,input supply to rivals, not just a supply realignment.

Further, even if there is an input monopolist but that monopolistsprice is regulated, a vertical merger can be used to evade price controlregulations. A vertical merger also can be used to facilitate price discrimi-nation, where price discrimination by an unintegrated monopolist wouldbe constrained by regulation or a competitive output market.

By contrast, when there is not perfect competition in the output mar-ket, a vertical merger has the potential to reduce costs and increaseefficiency by eliminating a double monopoly markup on input costs,When the output technology is not in fixed proportions, a vertica l mergeralso has the potential to reduce cos ts by eliminating distortions in efficientinput usage that arise from noncompetitive input prices.

Although the original Chicago School commentators focused primar ilyon the efficiency benefits of vertical mergers, they did identify somecompetitive concerns. For example, they paid close attention to the poten-tial for collusion and recognized evasion of regulation as a potentialconcern. Nevertheless, the original Chicago School approach placed littlecredence in the harm from foreclosure. This rejection of foreclosure asa competitive concern has two sources in addition to those identifiedearlier. First, the Chicago School approach is based on an assumptionthat barriers to entry generally are low. Second, the Chicago approachpre-dated the recent interest among economists in game theory andstrategic behavior. Along with other advances in economic theory, thegame theoretic analysi s of strategic behavior forms the core of what hasheen termed the post-Chicago approach.The strategic behavior modelsstudy the decisions of firms that take rivals like ly reactions to theirconduct into account when making their decisions. These involve modelsof strategic oli gopoly conduct rather than the models of simple monopolyand perfect competition that form the foundations of the traditionalChicago School approach.

See Oliver W ill iamson. Attl ifwl E+cenwr: When Its Been. Where IIS Going. 27 ST.LOUIS U. L.J. 289 (1983): Herbert Hovenkamp. AnLifnuI Policy After Chicago. 84 MICH. L.REV . 219. 274-80 (1985); Carl Shapiro, 7% Thmy o/Btuinrss Slrolcgy, 20 RANU J. ECON.125 (1989). Chicago School economist George Srigkr was a pioneer in the modern analyais ofoligopoly theory. George J. Srigkr. A Throty of Oligopoly. 72 J. POL. ECON . 44 (1964).However. that work had litt le impact on the Chicago Schwl approach 10 monopoly conductor vertical rclatipnlips. Cf. Carl Shnpin, & David J. Teece. Syllnu Compelition ondA/temar-

hrlr: An Ecamx Annlysir of Kodak. 39 ANTIT RUST .BULL. IS5 (1994).

19951 EVALUATING VERTICAL MERGERS 519These more realistic m odels of competit ive behavior form the basis for

a richer analysis of vertical mergers and their potential anticompe titive orprocompe titive effec ts. In such a light, vertical mergers should be neitheruniversally condemned nor universally applauded.

B. THE POST-CHICAGO APPROACH TO VERTICAL MERGERSBecause many vertical mergers create vertical integration efficiencies

between purchasers and sellers, man y if not most vertical mergers areeither procompetit ive or competit ively neutral. Potential efficiency bene-fits involve improved coordination in prici,ng, production. and designthat can reduce costs and improve product quality. They also involvemore efficient input usage and promotion.

Some vertical mergers, however, have the potential for anticompetitiveeffect s by creating, enhancing, or facilitating the exercise of marketpower. The co mpetition affected may be in the sale of inputs producedby one merger partner (the upstream or input market), the sale ofthe products produced by the other merger partner that uses theseinputs (the downstream or output market), or in markets that areancillary to the input and output marke ts.

Antitrust concerns regarding anticompe titive effec ts arise from threemain sources. First, vertica l mergers can lead to exclusionary effectsby increasing rivals costs of doing bus iness. This may involve raisingtheir input cost s by foreclosing their acces s to important inputs or fore-closing their access to a sufficient customer base. We refer to these respec-tively as input forec losure and customer foreclosure. This exclusio naryconduct may involve unilateral and/or the increased l ikelihood of coordi-nated conduct in the upstream and downstream markets.

tnpua arc the products and services used 10 produce the goods and services aald byfirma. These include such ccmventional inputs as raw materia ls. imermcdlate productswhich may be finished, energy. and labor. They may also include access10 product standardsand certification s, 1s well 1% wholes& and retail distribution services . As discussed inmore detail later. distribution somedme ~ can be properly viewed as an output in that thedistributor may purchase the praduct from the manufacture r. whereas in other situaliomdirwiburion can be properly viewed as an input into the production and sale of a pducl.These rhrec general classes of compc tidvc harm are recagnizcd in the 19R4 DOJMerger Guidelines, rupro ncxe 5. P 4.2. Hawever. only the mwt extre,mc cxamplc ofexcluaianary conduct is trcarcd in detail. The Vertical Merger Gu~dclm es focus 0 aMlmc whardif fcrentcxam plcof informadon exchange. Theanaly sisofcvasiono f reguladonis similar to the authors. Unilateral conduct refers IO behavior that inwIves independent strategies by cornpet-ing firms . Coordinated conduct refers 10 tacit understandings or agrccm cnls bclwecncompeting firma about what strategies IO f&w. .%I a lro U.S. Department of J,usdcc and

Federal Trade Com mission 1992 Horizontal Merger Guidelines B 2. rrpnntrd rn 4 TradeReg. Rep. (CCH) (I IS.104 [hcrcinaficr 1992 Horizontal Merger Guidelin esI.


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520 ANTITRUST LAW JOURNAL [Vol. 63Second, vertica l mergers can facilitate tacit or express coordinatedconduct by facilitating the exchange of pricing and other competitivelysensiti ve information in either the input or output market.Third, vertical mergers can permit a firm to evade a variety of pricingregulation. For example, a vertical merger can help a regulated firm to

evade cost-based, maximum price regulation by setting an artifi cial ly hightransfer price on inputs sold by the upstream divis ion to the downstreamdivis ion and, as a result, shift prof its from the regulated to the unregu-lated market. A vertica l merger also can help a firm to evade statutes orregulations that prohibit price discrimina tion.

C. THE FORD-AUTOLITE HYPOTHETICAL*The various theories of anticompetitive harm from vertica l mergerscan be illustrated and better understood in the context of a hypotheticalvertica l merger. Consider a styli zed variation of the Ford-Autolite

merger.* The acquisition involved the purchase of a spark plug manu-facturer, Elec tric Auto-Lite, by Ford Motor Company in 1961. For pur-poses of illustra ting the analys is, the input and output markets are pic-tured in the Bubble Diagram in Figure 1. To begin the analysis,consider a possible input market defined as the sale of spark plugs atthe wholesale level. This input market i s comprised of Autolite, Cham-pion, and A.C. Delco, a divis ion of General Motors, as well as a numberof fringe producers that sold mainly in the aftermarket. These sparkplugs are sold to the domestic automobile producers (OEM@. A keyoutput market for analyzing the vertical merger is the sale of new auto-mobiles containing spark plugs. The selle rs in this output market arethe domestic producers, Ford, General Motors, Chrys ler, and AMC, aswell as the foreign automobile manufacturers like Volkswagen that wereselling in the U.S. market at the time. In addition, as discussed below, anancil lary market comprised of aftermarket retailers such as The PepBoys,Sears, and so on, may be relevant to the analysis.

On the procompetitive side, the merger could reduce costs or improveproduct quality for both Ford and Autolite. The merger might permitFord and Autolite to coordinate better the design of a new generationof spark plugs, or to coordinate production. If the spark plug marketis imperfectly competitive, the merger might increase efficiency by reduc-ing the transfer price Ford pays for plugs and reduce Fords inefficient

W C will use th is cast to i l lustrate the analytic framew ork. not IO evaluate the valid ityof the result reached in the actual matter. To that end. w e will trcu the cast more as ahypothetical than as a real CPK and alter the assumed facts for i l lustradvc purpmca. Thehiamrical facts of the c=sc arc detailed in the d istr ict court opin ion. Ford Mator Co. v,United State% 286 F. Supp. 407 (E.D. Mich. 1968). @rd. 405 U.S. 562 (1972).

19951 EVALUATING VERTICAL MERGERS

MARKET\+-$/

Figure 1. Input foreclosure Ford-Autolite hypotheticalsubstitution away from spark plugs in response to a noncompetitivepremerger price, or it might better al ign the incentives of Ford andAutolite in other ways. These benefits could lead to more competitionin the spark plug and automobile markets.

On the anticompetitive side, there are three distinc t concerns. First,the vertical merger might harm consumers by excluding competit ion.Foreclosure in the input market would occur if the price of spark plugssold to Fords automobile competitors were raised, thereby enabling Fordto ra ise the price of new automobiles. Customer foreclosure in the outputmarket would occur if the other spark plug manufacturers-Champion,for example-were denied access to Ford as a customer. Such customerforeclosure might raise Champ ions variable costs or drive Champion


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522 ANTITRUST LAW JOURNAL [Vol. 63below minimum viable scale. thereby enabling Autolite to raise the priceof spark plugs either to OEMs. aftermarket distributors, or both. Second,the merger also might facilitate co llusion or pricing coordination amongspark plug manufacturers if Champion and Delco use Ford as a conduitfor exchanging information with Autolite, and vice versa. Third, thevertical merger might be used to evade regulations. For example, if theautomobile industry were subject to price regulation and Fords pricewere regulated on the basis of its costs, it might attempt to evade theregulation by having Autolite increase the price of spark plugs it sell sto Ford.

Using the hypothetical as background, a detailed framework for evalu-ating vertica l mergers and balancing procompetitive against anticompeti-tive concerns can be developed. Because vertical mergers generally areevaluated by the enforcement authorities before they are consummated,in this article we follow the approach of evaluating proposed vertica lmergers.

III. EFFICIENCY BENEFITS FROM VERTICAL MERGERSThe firs t area to be examined involves the efficiency benefits that mayresult from a vertical merger. A variety of efficiency benefits that can

reduce costs, improve product quality, and reduce prices may ensuefrom vertical mergers.A. THE ROLE OF EFFICIENCIES IN VERTICAL MERGER ANALYSIS

Antitrust takes the general view that cooperation among firms in avertical relationship in general has greater efficiency potential than d,,r:scooperation among horizontal competitors. It is consistent with basicantitrust principles, therefore, to place greater weight on efficiency bene-fits in analyzing vertical mergers than in analyzing horizontal restraints.PFor this same reason, vert ical mergers are evaluated under the rule ofreason?

In general, efficiency benefits can be weighed in evaluating the netcompetitive impact either by measuring the benefits on a case-by-case*See 1992 Horizonlal Merger Guidelines. ~upm Nate 23. 5 4. One impo rtant possibleexception concerns whether vertica l merger is necessary CO chieve the cla imed cffic iencics.rather than utilizing a contrac t ion of merger that does not involve the direct sharingof profita. Such an analysis of alternatives is carried out in the horizontal merger c cmt extunder the 1992 Horizonral Merger Guidelines.A vertica l contract short of merger ,ame,ime~ may be mom likely ,o bc suffic icn, ,oachieve efficiency b enefits, relative ,o ,he horizontal merger siuad on. One reamn is Iha,tirmr often are wary about cwperadng wi,h their compedmrs. A second is ,ha, cwperadon

with competitors necessary to achieve the cff ic iencics often will ra ise price-fix ing concerns. Condnental T.V.. Inc. v. GTE Sylvania Inc .. 493 U.S. 36 (1977).

EVALUA~~NCVERTKXL MERGERS 523basis or by adjusting the required threshold of competitive harm or somecombination of the two. Given that most vertical mergers generallyIcad to some efficiency benefits, it may be appropriate to adjust thet.breshold upwards, even before any case-by-case analys is of efficiencybenefits. That is, the complaining party would be required to demon-strate, as a threshold matter, a significant likelihood of consumer injuryeven before the merging parties are faced with the need to demonstratepositive net competitive impact on the basis of offsetting specif ic effi-ciency benefits flowing from the merger. Indeed, because vertical merg-ers often w ill not raise a significant likelihood of consumer harm, inmost cases it wil l be unnecessary to gauge the efficiency benefits of aspecif ic proposed merger to evaluate net competitive impact.

Where vertic al mergers both create efficiency benefits and raise significant competitive concerns, however, those conflicting effects must beweighed and balanced, so that the net economic effect can be measured.To &rive at the net economic impact, the sources of efficiency benefitsmust be identified. Those benefits may then be weighed and balancedagainst the sources of competitive harms.

B. SOURCESOF EFFICIENCY BENEPITSFROM VERTICAL MERGERSThe types of efficiency benefits flowing from verti cal mergers can be

organized into several categories for purposes of illustratiotxP 9I. Coordinalion in Design and Production

Vertical mergers can facilitate better coordination between input sup-pliers and output producers with respect to product design and produc-tion. Design coordination can lead to lower costs , higher product quality,and shorter lead times for new products. Feedback from buyers to selle rs

SW. e.g.. Boaw. supm now 4. a, 226; Tim othy J. Muris. The E/licim q Defrnrr UnderS~cfim 7 of ht Clqra hr. 30 CASE W. RES. L. REV. 381 (1960); Gary R oberrs & Steven C.S&p. Efficie ncy Benelitr in Dynam ic Merger Analysir (unpublished manuscr ip, on filewith author). Balancing eftic iency bencfio agains, campe,i, ivc harms ra ises a number of issuerregarding the economic welfare standard. the likelihood that CDS ,%wings will diffure 10other compe,i,ar% and whcrber a merger is rcaaonably necessary ,o aImin ,he cla imedbenefi,s. These i%sucswill no, be addressed here. For a detailed diwusaion in the horizontalmerger co,cx,, xc ltokrtr & Salop. ,upm no,e 27.wThir d iscussion ia no, imended IO be exhaurdvc. a lthough mw, effic iency cla ims canbc s,a,ed in ,errm of the ca,egories K, out here. For more cx,em ivc d ircuarion of eff ic iencybcneh,r, we Perry. rup note 15, a, 18% 191-92. S.rr a lso R,c~~a A. Poa~w. & FRAN KH. E~s~u ts~ooa , ANTITRUST: CASES. EC~N~M,C NOTES AND OTHEH M*- r ra ,~~s 869-70(2d cd 196,); Boas, ru,,ra now 4. a, 226-21 (1976): M ILTON HANDLE R LT AL.. &es *ND

MATERIALS ON TRADE RECUUT~ON 572 (1979); Condncn,al T.V.. Inc. Y. GTE SylvaniaInc., 433 U.S. 56. 54-57 (1977).


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524 ANTITRUST LAW JOURNAL [Vol. 63can improve quality control and lead to product innovations over time.Production coordination, by assuring supply or customers, for example,can lead to lower costs by reducing required inventories, rationalizingschedules to mitigate downtime and overtime inefficiencies, and optimiz-ing run sizes.

Such coordination may be facilitated by vertica l merger in that theparties can better trus t one another when they are pursuing a common,single-minded goal ofjoint profit maximization. In contrast, if the firmsare independent, the input supplier has the incentive to compromise theneeds of its multiple customers. Simi larly , the buyer may fear that itsideas are being used to benefit its competitors in the output market. Inshort, vertica l mergers can reduce the potential for opportunism.*

Although these potential benefits are real, they do not Row automati-call y from every vertical merger. In addition, in industries in whichtechnology entails only partial ver tical integration, in which certain unin-tegrated firms are dealing with integrated rivals, some of the coordina-tion benefits necessarily may come at the expense of imposing highercosts on rivals. For example, if an input must be designed to uniformstandards and the integrated firm chooses the standards preferred bythe downstream division, those uniform standards may be inferior forother unintegrated customers. A compromise standard may not be cho-sen by the integrated firm even if it is optimal.

2. Eliminating Free Riding by Intcmalizing IncentivesVertical integration can eliminate premerger free riding by eithermerger partner. This benefit occurs by coordinating the incentives ofthe merger partners to carry out actions that benefit the other. Just asintegration can alter incentives in a way that harms competition, integra-

Thomas M. Jordc & David J. Tcecc, howlion and Cwpcrotion: lmplicotionr for Compcri-lion ondhlilrusl. 4 J. ECO N. PEISP . 15 (1990) (asacrting tha t innovalion requires feedbackmechanisms between firms). MICHA~.L E. PORTE.. COMPETlTlV~ STKAUTECY: TECHNIQULSFOI(ANALYZING l~ous~a,csAND COMPE TlmRS (1980). Set Ronald C oast. ThrNohrrcof tht Fin. 4 ECONOMICA 986 (1997): OLIVER E. WILLIAM-SON, MA~KETSANDHIERARC~IES: ANALYSI~~NDANT~TRUSTIHPLICAT. IONS(I~~~) : Ben jaminKlein et a l.. V&ical Intcpnhon. ApPmpGblr Renti and the Carpcfit iv t Conrrncling Proust. 2 IJ.L. & ECON. 297 (1978); M ichael H . Riordan &Oliver E. Will iamson. Aurr Sprctfic iry andEconomic Orsvzniuuion. 3 INTL J. INDU S. ORG. 365 (1985); David J. Tcecc. Vrrl ica l In lrgrorionad V&ml Diverlirure in the U.S. Oil Indwhy. lnaritutc for Energy Studier. Stanford Univ.( 1976). Ed see Richard Lcvin. Vertical lntcgnrtion and Pmjitabi bry in thr Oil Indwlry, 2 J,ECON . Brw.,v. Oat. 215 (1981).*These issues arc discusse d in more detail in Joseph Farrell & Garth Saloner. Sylm-

Compelif lon Vrrsur Conponrti Cmnprli l ia . Paper Presented at FTC/DO J/ABA Conference,P#,st-Chicago Economics: New Theories-New Cares? Wash.. DC.. May 26-27, 1994.

I QQ5] EVALUATING VERTICAL MERGERS 525tioo also can alter incentives in ways that benefit competition. This effi-ciency also is closely related to the coordination efficiencies discussedabove.

Consider the impact of product promotion by the downstream firmbefore the merger. Promotion can raise the profits of the firm by increas-ing demand for the product. Before the merger. for example, Fordwould balance the costs of promotion against the increased net revenue(i.e., revenue net of costs) like ly generated. Ford would not, however,cake into account any increased net revenue flowing to its independentinput supplier, (say) Autolite before the merger, from the demandgenerated by the promotion. As a result, promotion that can lead toincremental joint net revenue to Ford and Autolite that exceeds theircombined incremental costs may not be undertaken.

In contrast, a vertica l merger will internalize the benefits to the inputsupplier. In making its decis ions, Ford would take into account the impacton Autolite. This change in the incentives of the downstream divis ionwill lead to increased downstr eam promotion that increases the profitsof the integrated firm. A similar analysis can be carried out for upstreampromotion or other investments by e ither party.

When the input market is not perfectly competit ive. the input pricemay exceed the marginal cost level. which leads to ineffic ient usageamong substitutable inputs absent vertica l in tegration. For example, suppose imperfe ct competit ion among sp ark plug producers leads to non-competitive spark plug prices. In that case, automobile producers havethe incentive toengage in cost-reducing input substitut ion, such as electri-cal or fuel injection system changes to improve spark plug life, or areduced number of cylinders.

Although th is type of substitution may be cost-effective from the buyers view because the input is priced high in exces s of marginal cost , itdoes not lead to economically eff ic ient input usage. Economic effic iencydictates that input usage be determined by marginal costs, not by pricesthat exceed marginal costs. A vertical merger may eliminate this ineffi-cient input usage when the integrated firm supp lies inputs to itself.The integrated firm generally will transfer the input to its downstre am

sI For example. suppose that promodonal expenditures by the downstream firm of $100lead to increased net revenue 10 the downstream firm of $80 and incrcarcd net revenueto the upstream firm al $50. This prom adon will be forganc before the merger becausecosts ($100) exceed downstream benefits ($80). Hawevcr. it wil l be undertaken after themerger bccauac total bencfirr ($130) excee d cm@ .


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ANTITRUST LAW JOURNALdivis ion at marginal cost, not at a price in excess of marginal cost. Asa result, the integrated firm may be able to reduce it scosts , which providesit with the incentive to increase its output and reduce its output price,Although this is an efficiency-based rationale for vertical merger, thebenefits may or may not be sufficient to offset the competitive harmsfrom anticompetitive exclus ion or other sources.~

4. Eliminating Double Markup of CostiWhen both the input and output markets are imperfectly competitive,output prices are increased above the competitive level and possibly evenabove the monopoly level, as marginal input costs are marked up twice,

once by the input supplier and once by the output producer. Under thesecircumstances, when the integrated firm can efficien tly supply inputs toitself, a vertical merger of a firm with a supplier of a variable input canreduce output prices by eliminating one of the two markups. This resultoccurs because the integrated firm will have the incentive to transfer thevariable input to the downstream divis ion at a transfer price equal tomarginal cost, which then wil l be marked up by the downstream division,Thus, the vertical merger can reduce output prices and increase con-sumer and aggregate economic welfare. In th is way, a vertica l mergercan be a consumer-benefiting correction to an imperfectly competitiveinput market.

To evaluate the magnitude of this potential efficiency benefit, thestructure of the upstream and downstream markets must be evaluated.

I*- either market performs competitively before the merger, there willbe o. double markup. In that case, no efficiency benefit wil l occur.Instead, th is efficiency benefit is dependent upon the input market fora variable input being imperfectly competitive. Even in this case, however,if the downstre am division of the integrated firm is a big buyer that wasable to negotiate a nearly competiti ve price before the merger, then thedouble markup will be small and the efficiency gains will be limitedaccordingly.

Assuming that the integrated firm can supply significant variable in-puts to itself and a significant double markup can be eliminated, it willbe necessary to balance these efficiency benefits against any competitiveharms identified. In some circumstances, the combination of eliminatinga double markup and foreclosure may lead to the need to balance pr icereductions by the integrated firm against cost and price increases byunintegrated competitors.

In lernal transfer prices in cxc css of costs may bc used 10 provide incentives 10 theupstream and downstre am division in a decentralized organization struc~u rc. They mayalso be used in certa in c ircumstances as a basis for management compensation 1% mcrhodof facil ita ting coordination in the downstream market. Chaim Fcrsrmann & Kenneth L.Judd. Equilibtium lncmtiw in Oligopoly. 77 Au. ECON. RPV. 927 (1977).s If eff ic iencies arc evaluated on a case-by-case basis. the conditions necessary to causeoutput price to fall could. in principle, bc evaluated for this monopoly cast . To illustraleth is, consider the cxtrcmc cast in which a monopolist input supplier merges with one ofa number of competit ive downstream output producers. That monopolist wil l have theincemi vc to engage in input foreclosure PS well as to rationalize its input usa8c at thedownstream level. Taking both incentives into account s imulcaocoualy. the impact onoutput prices depends on demand and cost conditions. Thus. consumer welfare andaggregate econom ic welfare could fall. dcspire the efficienc y benefit. For further discussiono mput usage, YC Parthasaradhi Mall& & Babu Nahala. The Tkwy oj Vertical Control

wzth Vati& Pwportionr. 88 J. POL. ECON. 1009 (1980); Herman C. Quirmbach. Thr Porbo/P& Changes in Vcrlica l Integralion. 94 J. POL. ECON . I I IO (1986); Michael A. Salingcr,Vrrtica l Mergers and Market Foreclosure, IO3 Q,J. ECON . $45 (1988); Frederick R. Warrcn-

5. Effic iency Loses Suffered by Foreclosed CompetitorsWhere a vertical merger increases the costs to unintegrated competi-tors, those increased costs do harm r ivals . However, they do not necessar-ily represent real efficiency losses. Real efficiency losses are involved onlyto the extent that the higher costs are not simply transfers to inputsupplie rs but rather lead to inefficient input usage by the competitors.

There also are efficiency losses when resource use in the output marketis distorted by precluding lower-cost production by efficient competi tors.

The competitive analys is of vertical mergers also involves an examina-tion of the competitive concerns that can arise. These competitive con-cerns can be class ified into three categories: anticompetitive exclusion,information exchange, and evasion of regulation. In the next three sec-tions, we analyze those competitive theories in detail.

IV. ANTICOMPETITIVE EXCLUSION

Boulton. Vertical Control wilh Vakble PropooPonr. 82 J. POL. ECON. 789 (1974); MichaelWaterson. Vnlical In legmtion. Vatiblr Proptionr and Oligopoly. 92 ECON . J. 129 (1982);Frederick W estfield . Vrrfical Inlrgrolion: Dorr Product Price Riw or Fall?. 7 I AM. ECON. REV.534 (1981): src nbo Perry. so @, note 15.

Vertical integration by merger can increase the merged firms incen-tives to engage in exclus ionary conduct in its pricing, marketing, andpurchasing decisions at both the input (or upstream) and customer (ordownstream) levels . At the input level, this may involve the upstreamdivis ion raising the input price it charges to rival s of the downstreamdivis ion or refusing to supply them. At the customer level, this may

See Herbcn Spenglcr, Vmicol Inlegmlion and Anlilnul Poliry. 59 J. POL. ECON. 347(1950); Fritz Machlup & Martha T.&r. Bilnftra lMonopoly. Surcrrs ivc Monopoly. and Vtrtirol When inputs are d iffcrcndatcd. lhe inugratcd firm may suffer some incfl ic icncy bysupplying inputs t o itself if the input produced internally is not the optimal variely.

I9951 EVALVATINC VERTICAL MEUCERS 527


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528 ANT~TRWT LAW JOURNAL [Vol. 63involve refusing to purchase from rival input suppliers. This exclusionaryconduct may involve purely unilateral behavior or the vertical mergermay facilitate pricing coordination at either leve l. Competitors may beharmed by having their costs raised above the premerger level or bycausing them to exit from the market. The conduct may harm competi-tion by giving the integrated firm the power to raise or maintain inputor output prices above the competitive level.By increasing the likelihood of anticompetitive exclusion. verticalmergers permit the integrated firm to achieve, enhance, or maintainmarket power, the essence of what is proscribed by the antitrust laws.A finding that input foreclosure raises a real potential for harm to compe-tition, however. does not mean that, on balance, a proposed verticalmerger necessarily is anticompetitive. Likely efficiency benefits also mustbe weighed in order to gauge the likely net competitive impact of atransaction.

A. INPUT FORECLOSUREInput foreclosure refers to exclusionary conduct by the upstream divi -sion of an integrated firm with the purpose of excluding riva ls from

access to important inputs or raising their costs of such inputs. Theincentive for the upstream divis ion to exclude or raise the input priceit charges to the competitors of the downstream divis ion is easy to explain.By raising thei r input costs or otherwise excluding downstream rivals,an integrated firm can place downstream riva ls at a cost disadvantage inthe downstream market. Other input supplie rs may not take up the slackbecause, for example, their abili ty to expand is limited, their effectivemarket power has increased, or the input foreclosure itself facilita tescoordinated pricing among input suppliers .

In these cases, if downstream riva ls costs are raised, the integratedfirm may be able to effect an exercise of market power in the downstreammarket. either unilate rally or through coordination with its competitors.The parties to the downstream coordinated conduct may include thosecompetitors disadvantaged by the higher input costs or other exclus ion-ary conduct. In a sense they are induced to cooperate somewhat involun-tarily as a result of their higher costs. In this way, the integrated firmachieves market power. that is, the power to raise or maintain priceabove the competitive level in the output market.

The integrated firm may nat haveclas sica l nilateral market power. that is, the power10control price by profitably restric ting its own ourpul. Instead. it achieverexclusionarymarket power. thal is, the power to raise price above the competitive evel by excludingcompetitors and forcing other market participants o raise prices.An integrated firm thatachieves xclusionarymarket power may remain a price.rakcr n a seeminglycompctitivc

19951 EVALUATING VERTICAL MERGERS 529This exclusionary conduct harms consumers through higher down-stream prices. E fficiency also can be reduced in two ways from this

c-onduct. First, the consumer deadweight loss involves an efficiency lossas consumers reduce their purchases. Second, the higher cost borne byrival s may lead those firms to utilize an inefficient input mix and themarket shares of relatively more efficient firms may also be reduced.The input foreclosure theory can be illustrated by using the hypotheti-cal version of the Ford-Autolite merger and the Bubble Diagram inFigure 1. The acqu isition by Ford gives Autolite the incentive to increase

its prices to Fords rivals in the domestic automobile market. thus giving&Is saddled with higher costs the incentive to raise the price theycharge for automobiles or cut back their output. In this way, Ford gainsbecause it can increase its own price, its market share, or both. Thus,Fords exclus ionary conduct gives it market power-the power to raiseprice above the previous, more competitive level-and consumers areharmed by the higher automobile prices.

The merger-induced incentive to raise input prices arises because thedemand for inputs and the demand for outputs are interrelated. Forexample, if the upstream divis ion raises the input price it charges to theriva ls of the downstream division, the downstream divis ion wil l be ableto sell more output at the premerger price. Before the merger, theupstream and downstream divis ions make profit-maximiz ing price andoutput decisions without considering the effect on the others profitsthat flow from these demand interdependencies. After the merger,these demand externalities can be factored in, thereby possib ly increasingthe incentives of the upstream divis ion to raise its prices to the benefitof the downstream division.

There are a number of economic factors that affect the incentives ofthe integrated firm to raise input prices, the likely magnitude of anyincrease, and the overall profitabil ity of the strategy for the integratedfirm.1. Four-Step Andysir of Pofdid Antimmpetitivc Harm: In Cmeral

Evaluation of the likelihood of competitive harm from input foreclo-sure and the incentives of the integrated firm to carry out an inputforeclosure strategy involv es a four-step analys is of the input and outputmarket. ScrThomas C. Krlltcnmaker ct al.. Manopoly owr ad Moht Power in Antitnullaw, 76 CEO. L.J. 241, 258 (1987). This incentivesanalysis s oormaliud in the Appendix to this aniclc.

The facl that incentivesare imernalizcd does no, imply that 1 vertical merger isanticompetitive. The effi ciency bencfi~ identified earlier in Put 111also arise from theinternalization of incentives.


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530 ANTITRUST LAW JOURNAL [Vol. 63markets after the proposed merger. This analys is includes evaluation ofmarket structure, conduct, and performance that is similar to conven-tional analys is of horizontal mergers, but tailored to the context of thespecific competitive concerns involved in foreclosure analysis.

This four-step analys is is intended to evaluate the likelihood and magnitude of harm to competition, absent efficiency benefits. It also is in-tended to evaluate harm to competitors and profitabil ity of the strategyto the integrated firm. This analysis then is combined with the evaluationof efficiency benefits in order to gauge the likely net competitive impactof the proposed vertical merger.

The fi rst step evaluates the impact on input prices and rivals costs.The inquiry here focuses on whether competitors costs of the foreclosedinput likely wi ll increase after the vertical merger as a result of a changein incentives of the newly integrated firm and its input market competi-tors. If unintegrated riva ls can substitute to equally cost -effective alterna-tive inputs and effective input market competition is not reduced, thenthere would be no competitor harm. This analys is also evaluates thelike ly impact on the profits of the upstream divis ion.

The impact on output prices Rowing from any cost increase is evaluatedin the second step. It analyzes the likely magnitude of the increase inriva ls costs and its implica tions for performance in the output market.The inquiry here focuses on whether output market prices like ly wil lincrease or whether, instead, ri vals in the output market will maintainthe abilit y and incentive to compete vigorous ly. In this way. the secondstep evaluates whether or not consumers in the output market areharmed, assuming first that the merger raises the costs of its rivals.The analysis in the second step also evaluates the profitabili ty of thedownstream division.

The third step evaluates the impact on prices in any ancil lary marketsrelevant to the inquiry. Anci llary markets may be affected when pricediscrimination in the input market is infeasible or where there are de-mand or supply complementarities. For example, when Autolite raisesbattery prices to the auto manufacturers. it also may need to raise pricesto aftermarket retailers. The inquiry here focuses on the impact onconsumers, competition from rivals , and the profitabil ity of the inte-grated firm.

Net anticompetitive impact i s evaluated in the fourth step, in whichthe relative magnitudes of efficiency benefits and anticompetitive harmare weighed and balanced. In light of the potential for efficiency benefitsand other concerns. courts have now made it clearer that higher input

1995J EVALUATING VERTICAL MERGERS 531costs and harm to competitors do not by themselves demonstrate injuryto competition. The evaluation in Step 3 may demonstrate that competi-lioL1 among downstream firms may remain vigorous so that prices do,,ot rise relative to the relevant competitive benchmark. In this case,there would be no competitive harm, even if competitors are harmedby the merger and there are no efficiency benefits. This is a stringentstandard that will permit most vertical mergers. Moreover, once thelike ly efficiency benefits from a particular vertical merger are evaluated.even fewer vertica l mergers will be found to have an adverse net effecton competition.

If a vertical merger does not cause riva ls costs to increase, then thoseexcluded competitors would not be harmed. More important, the newlymerged firm would not gain market power and there would be no con-sumer harm in output markets. In that case, the profitabil ity and incen-tive of the upstream divis ion to raise its input prices or otherwise excludedownstream riva ls also would be reduced, if not eliminated.

Rivals costs may increase if rival input suppliers do not have the abilityor incentive to expand output at current prices and if alternative inputsare imperfect substitutes. A number of factors are relevant in evaluatingthe incentives and abilit ies of riva ls to expand, the potential harm toexcluded competitors, the incentives of the integrated firm to carry outan input foreclosure strategy, and the impact on consumers.

a. Avai labil ity of Substitute InputsIf output riva ls can easil y substitute to other equally cost-effectiveinput suppliers, then those rivals will not be harmed. As a result, theintegrated firm wi ll have no incentive to attempt input foreclosure. Thisevaluation involves identifying close input demand substitutes in theevent that the upstream divis ion of the integrated firm were to increase

the input price it charges to rival s of the downstream division. Theseclose substitutes include the remaining current producers of the sameinput plus producers of alternative inputs that are equally cost-effective.This analys is in effect identifies a narrow hypothetical relevant marketof equally cost-effective, nonforeclosed input suppliers .Se Eastman Kodak Co. v. Image Technical Sews.. Inc.. II2 S. Ct. 2072 (1992); stc

olro Bmokc Group Ltd. v. Brown & William wn Tobacco Corp.. I13 S. Ct. 2578 (1999).The proper competidve benchmark would be the price that would occur but for the

vertical merger. This usually w ould be the current price. However. in some circumatancer.it might bc a higher or lower price.


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536 ANTITRUST LAW JOURNAL [Vo l . 63aftermarket spark plugs.s Even with a uniform input p rice equal to (say)$105, that price increase would sacrifi ce some aftermarket profits becausethe new price i s above the profit-maximiz ing $100 level. These los t profitswould moderate Autolite s incentives to raise price. Perhaps it insteadwould choose to raise the uniform price only to $102, i f at all.

The reasoning (but not the result) is altered somewhat when the profit-maximizing price to nonrivals in the ancil lary market segment (e.g.,aftermarket sales) exceeds the optimal price to riva ls (e.g., OEMs). Inthis case, if discrimination were infeasible, an increase in the uniformprice actually would enhance the profits earned in the ancill ary market.Even in this case, however, if price discrimination is infeasible, the opti-mal input price increase is moderated. This i s because the premergerprice is higher to begin with. Moreover, the profits of the downstreamdivisi on that are taken into account after the merger are a smaller shareof the total profits of the upstream divis ion affected by a uniform inputprice increase than they would be for a discrim inatory price increase.Thus, the extra component of profits created by vertical integrationwould have less impact on the optimal pricing by the newly integratedfirm.s

This moderating influence of nondiscrimination on post-merger priceincreases may be mitigated if the vertical merger facilitates greater pric-ing coordination in sales to the noncompeting purchasers. First, a uni-form price increase by Autolite may cause rival battery manufacturers

ld This ~ssurncshat competitora do not raise their prices.an issue hat is discussedb&w.

For example. suppose that aftermarket buyers arc more will ing to substitute amongspark p lug brands than are OEMs. In that case. even a very small increase in its uniformprice might cause Aulolite 10 lose virtwdly III of its aftermarket sales. Accordingly, Awolitcmigh1 ewn choose to cominuc 10 price a1 $100. (This is an example of 1he discominuousupstream profit funcrion discussed in the Appendix.)

ss For example. in the Aulolil c hypothetical. soppow that the OEM channel accountedfor 90% of spark plug sales and the aftermarket accounted for 70% of sales. Suppose thatif price discriminatio n wereper case 10 the OEMs and r

saiblc. the integrated firm would charge a price of $100I IO to the ahcrmarkcr. Suppose furlher 1ha1 1hc vertical

merger would induce the integrated firm 10 raise the OEM price by $10 to II IO. if pricediscrimination WC TC ossib le. If price d iscrimination were impossib le. however. supposethe prcmcrger uniform price in itia lly wcrc set at $107. a price c loser to the aftcrmarkeerprice because rhal segment .wcounts for such a h igh percentage of the business. (As anillustradve first approximadon . we assume 1he uniform price is a weighted average of 1hcdiscrimina1ory prices. with weighe equal 1o the shares of sales.) In that EPK. the mcrgcrmigh1 increase the uniform price by only IS 10 $I IO. The uniform price increases by lessbccausc the OEM segment is $107 to begin with. (Of course. unlike the first example. atthe post-merger price of II IO. afwrmarket profits no longer arc sacrif iced by rhe need10 charge a uniform price.) If the ancillary marke t were (ray) 90% of the business . thenthe merger might only raise the input price b y $1. from $109 10 $I IO.

lon5) EVALUAT~NC VERTICAL MERGERS 537to laise their prices in response. Thus, it is possible without price discrimi-Ilati1nl that the vertical merger might cause Autolite to lead a generalI)ricc increase. Second, the vertical merger might make Autolite a morewilling participant in a cartel or in coordinating prices because Fordbenefits when its competitors pay higher pr ices for batteries. Thus, thewrtical merger may induce Autolit es aftermarket competitors to raiseaftermarket prices in the belief that Autolite will follow.

Ihis analysis is complicated by yet another factor. Even where aninability to price discrimina te does moderate the input price increase,the overall input market impact i s not necessarily reduced. This i s becausean input price incre ase now would apply to a broader class of custom ers.absent discrimination, aftermarket purchasers also would suffer a priceiwrease. Suppose also that absent price discrimination the size of theprice increase following vertical integration is proportional to the shareof Autolite s sales made in the output market segment. In th is case, thexggr~gate consumer harm resulting from the vertical merger i s roughlyindrpcndent of the aftermarket share of Autolite s sales. For example,suppose that aftermarket sales represent 90 percent of Autolit es salesand price would increase by $10 with price discriminat ion and $1 absentprice discrimination. Aggregate consumer harm would be the same,because a $1 increase to 100 percent of the market is equivalent to a$10 increase to IO percent of the market.w

In summary. the impact of an inabil ity to price discriminate raisesc-onsiderations that complicate the analys is of input prices and riva lscosts. While very little can be concluded given our analysis to date, theanalysis does suggest that an inability to price discriminat e is a moresignificant constraint on the profitabili ty of input foreclosure and lesslikely to cause large welfare harm where (I) the profit-maxim izing post-merger price in the output market segment exceeds the prolit-maximiz-ing price in the ancillary marke t segme nt, were price discriminationfeasible; (2) a nondiscrimin atory price increase does not facilitate coordi-nated pricing in the ancillary market segm ent; or (3) the size of theancillary market segment dominates the size of the output market seg-

s If demand in the ancillary marker scgmcnt is more clasric. 1hcn a uniform pricemcreasc may be less 1han proportional to the shrrc of Au1ali les sales made in char segmcm.Tbis is because 1hc los1 salts in 1hc af1ermarkct are more d isciplinary. This case carrcspunds10 the siuation where Autol ires preferred af1ermarkc1 price is less than i1s preferred OEM~wce. were discriminat ion possible.

*I Moreover. when price discrimina tion is possible. only the nonirwgraad segment 01lbe outpu1 mrrket cxpcricnces a price increase gecruse of [his. when rhe proportionalityassumplion holds, the aggregate harm 10 consumers from a urdform price increase w ouldbe higher.


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538 A N TI TR U S T LAW JOURNALmerit, so that any post-merger uniform price increase would be de mi-nimis.B

f. Acquis ition of a Disruptive Input PurchaserIf the vertica l merger invo lves a particularly disruptive input purchaserthat competes in the output market, that may facilitate price increases

by the selle rs in the input market. For example, if one input purchaserthat competes in the downstream market is able to negotiate low inputprices before the merger, those low prices may cause riva l input selle rsalso to charge lower input prices to the disruptive firms rivals. Thisincentive arises from fear of losing more profitable input sales as thedisruptive firm expands on the basis of its cost advantage. Alternatively,if upstream firms view sales to a particular buyeras sufficiently important,perhaps because of the size of that buyers aggregate purchases, theymay deviate from the terms of coordination in an attempt to gain salesfrom that firm. Under certa in conditions, this could disrupt a marketwideagreement.

If such a disruptive firm merges with an upstream competitor, itsdisruptive influence wil l be reduced. It will have no interest in disruptingupstream pricing coordination directed at its rivals. It will have a greaterincentive to match the higher price of its downstream rival s in order tofacilitate the coordinated input pricing. Thus, in situations where thedownstream merger partner previous ly had been a disruptive inputbuyer, it is more likely that the merger will lead to input price increasesthat raise rivals costs.

3. S&p: Anlicompcliliue Impad in Ihe Outpul MarketEven if the higher input price increases the costs of certain riva ls thatare the targets of the input market foreclosure, that does not by itself

1I In s~rne inpu, mark ets. it b s,a,u,o ry or regulatory prohibi,ions ra,her ,han infbrma-lional and arbilragc conslraints rha, serve IO prcven, pas,-merger price discriminrdonagainst rivals. Howeve r. ,hcse legal provisions may be inadequair constrain ts on ihe pricingbehavior of ,hc newly in,egra,cd firm. in light al ,he difficulty in properly evaluatingcompetidon-base d and con-based jusdficaiionr for price differentials and dc,cc,in g theuse of nonprice methods of d iscrimination. For example. after rbc merger. cornpAnginpu, suppliers migh, rahc ,heir inpu, prices in ,he cxpectado n that ,hc upstream divisionof ,he imcgratcd firm will ra ise i,s prices. In thr, case. ,hc in lcgra,ed firm might ,ry ,oargue tha, i, was simply m eeting com pctil ion when i, raised hs prices. In evaluating ,h iaclaim. how will ,bc couro and regulalory authorities know which price is the chickenand which is ,hr egg? Moreover . even where regularion can deter, price discrimina,ion.permitting ,he merger would require ongG,tig rcgulamry scrutiny of ,hc merged entityand may prcven, dcrcKuln,ion ,hal u,hcrwir c would be in the public imeres,. Wherercgula,urs face such monimring prublcms. ICIP ower should bc a,,r ibu,cd 10 an,id iscrimi-ru,iun regulations.This Ialter ilnalyrir hrm s ,he basis f& %4.222 (Elimination of a Dirrup,ivc Buyer) inrhr 19X4 Dcparlm ent of Juslicc Merger (Aidelines. Srr 19X4 D0.J Merger Guidclinrs.

IO95 1 EVALUATING VERTICAL MERGERS 539impel a finding of consumer injury. Competition from other down-~rea,n producers whose costs are not raised and demand substitutionto other products may prevent the downstream divisi on of the integratedhrm from leading prices upward. This competition from nonexcluded(irms generally will be a significant constraint on the abilit y of the newlymerged firm to raise prices. A number of factors contribute to the evalua-tion of the competitive impact in the output market. This analysis of theuutput market also has implicat ions for evaluating the potential gains inprolitability to the integrated firm from implementing an input foreclo-sure strategy and, thus. its incentives to attempt the strategy if the pro-posed merger is consummated.

a. Availability of Substitute ProductsII output consumers easily can substitute away from both the fore-

closed compe titors and the downstre am division of the integrated firmwhen they ra ise prices of other products, without suffering a reductionin welf8re or effective costs, then consumers will not be harmed by theinput market foreclosure. This analysis in effect would identify a re levantdownstream market of nonforeclosed competitors, including close de-mand substitutes and the newly integrated firm.

b. Post-Merger Competition in the Output MarketAssuming that the costs of certain downstream riva ls are increased by

the input price increases or other input m arket foreclosure, the competi-rirm provided by those riva ls likely will decline. However, if other outputproducers costs are not raised, including other vertically integratedfirms, competition from those firms and from producers of close substi-tute products may prevent output prices from ris ing above premergerIrvels. In this case, there would be harm to competitors, but not tocompetition.u@ note 5. a, 20.567. The G uidelines are susceptible ,o ,he cri,icbm ,ha, under ccr,ain8onditions the sellers migh, condnuc ,o coordinate their price s ,o buyers other than thedisruptive buyer.

In carrying out this cvaluatian. Ihe analys musl be careful 10 avoid lhc C~llophnnrfa llacy. The an,icumpe,i, ive effects of some proposed vcrdcal mergers may no, /m&xwiring prims abwc currem levels but, rather. prcvenling pricer from falling down ,olower. rnme compe,i, ivc levels by deterring en,ry or cou rcducdons of r iva ls. If wo, ,hcdclerminadon of ,hc relevant markc l should be scnsiliv c ,o the price dow n naiure af,hc allcgadon. The r&va n, marke , should nag be defined by rcfcrenre ,o price increases:I~VC ,hc currcn, level because such price increases are no, ~clcvam 10 ,hr an,icompc,i, ivcconccmr. For a d iscussion of ,hc Cdlaphanr fa llacy. aris ing in United Stales v. E.I. duIonl de Nemourr k Cu.. 35, U.S. 977 (1956). see Kral,enmakcr e, a l.. .supm 0,~ Xl, a,256-57 n.5. and the rcfercnccr c i,ed therein. .%I obo Easmxm Kodak C u. V. ImageTechnical Servr.. Inc.. I12 S. C,. 2072. 20X4 (19%).


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542 ANTITRUST LAW JOURNAL [Vol. 63an impact on the like ly increase in the output price and many have animpact on the like ly output expansion of the downstream division aswell. For example, the degree of product differentiation also impactsprofitabili ty, as discussed below.

d. Acquisit ion of a Maverick Competitor in the Output MarketA vertica l merger with a downstream partner who is a maverick, thatis, a particularly vigorous and disruptive competitor in the downstreammarket, may facilitate coordinated price increases in the output marketafter the merger.O If a maverick firm merges with an upstream competi-tor, its incentive to engage in disruptive competitive behavior will be

reduced. It will have a greater incentive to coordinate its prices with itsdownstream riva ls in order to facilitate coordinated input pricing thatbenefits its upstream partner. Thus, in situations where the downstreammerger partner is a maverick, it is more lik ely that the merger will leadto output price increases.e. Product Differentiation in the Output Market

Where products in the output market are highly differentiated, nonco-ordinated competition is less intense than for more homogeneous prod-ucts. This i s because demand substitution among them is limited. In thatcase, higher prices charged by foreclosed competitors may not lead thedownstream division of the integrated firm to raise its own price by muchin response. In contrast, if the products are closer substitutes, then theintegrated firm has the incentive to raise its output price by more inresponse to the foreclosure induced by the merger. Thus, the impacton prices in the output market will be greater when the products aresomewhat close r substitutes.

In addition, when the products are differentiated, the integrated firmhas less to gain from input foreclosure. This follows because the priceeffect is smaller and the downstream divisio n is unlike ly to expand byas much. This information is relevant in evaluating the integrated firmsincentives to raise input prices to begin with as well as its incentives to

This zmalysis obviously is closely relawd to the dircusr ion of dirrupdvc buyers above. For example. in the l imit ing case. i f there is no demand subaitudon be~cen the f irms.the imegrntcd f irm wil l nut have the incentive LO raise its pr ice at al l .?This explains the coumerintuit ive nature of the impact of product dif fcrendadon.One might expect product differendarion w increarc the likelihood of post-merge r priceincrcaxs because dif ferendadan tends to produce higher pr ices in markets in which pr icingis not cwrdinawd. Far some illustrative calculations. see Table I in Ordover. Equil ibr ium. ru@~ note 15.

al 137. .%I nlrn Har, & Tirolc. Sjh ,C 37.

19951 EVALUATING VERTICAL MERGERS 543undercut its competitors coordinated input price increases, as discussedearlier.

f. Magnitude of Increase in Rival s CostsThe greater the impact of the input foreclosure on riva ls costs, the

greater will be the effect on output prices, all things being equal. As aresult, the potential harm to consumers in the output market will begreater. In addition, the gains to the integrated firm wi ll be greater,which w ill lead to a greater incentive to undertake and stick with aninput foreclosure strategy.

Prediction of the magnitude of the like ly impact of a proposed verticalmerger on rivals costs may be complex. This is because the magnitudeof the input demand elastic ity and the cost share of the foreclosed inputare related. This relationship leads to countervailing effects on the pre-dicted increase in riva ls costs and downstream prices.

If the foreclosed input represents a small share of the rivals costs,then any given percentage input p rice increase involves a smaller overallpercentage cost increase. For example, if the premerger price of a setof spark plugs were $25 out of a total manufacturing cost of $2,500,which then was doubled to give a wholesale auto price of $5,000. thena 100 percent increase in the price of plugs to $50 would only raise thewholesale price to $5.050. an increase of 1 percent.

However, when the foreclosed input represents a small share of riva lscosts, then the derived demand for the input is less price elastic. Thisimplies that the resulting percentage increase in the input price is poten-tially larger if a vertical merger leads to weakened input market competi-tion. In the extreme, if a set of spark plugs i sessentia l to the constructionof an automobile, then a plug monopolist could, in effect, control theautomobile market and extract all the monopoly profits. This is an

Set in/r0 Part tV .A.4.c. For example. i f an input rcprcscnts 10% of a f irms costs and the pr ice of the inputr ises by 20%. then the f irms costs wil l r ise by 2%.That is. the new manufactur ing cuss wauld r ise to $2.525. which upon doubling givesa wholesale pr ice of $5.050. Bccauw overall costs do 01 r ise by 1~ much when rhc CM share is low. a given increasein input pr ice wil l not reduce demand by ar much.* For example. i f the monopoly whalesale pr ice were $7,500, a spark plug monopolistcould charge pe rfect ly compeddve auto manufacrurcrs $5.025 for a SCI of plugs. Theremaining manufaclur ing c03U arc 12.475. which would imply a total CDILLO he producerof $7.500. I f whalesale compctidon were perfect. then the wholesale pr ice would equalmarginal costs of $7.500. Even if autamabilr manufacturers arc not perfccdy co mpait ivc.the plug monopolisr could charge an extraordinary pr ice. For example. assuming lhat themanufac turing cost will be doubled. a price of pluga equal to $1.275 would im ply amanufxturer r CDS~ f $5.750. which upon doubling yields the monopoly pr ice of $7.500.


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544 ANTITRUST LAW JOURNAL [Vol. 63application of the general antitrust principl e that there is greater r iskof collusion and pricing coordination when demand is inelas tic.Y

The net effect of the input cost in relation to the rivals overa ll productcost depends on the structure of the input market. For example, in thecase in which inputs are used in fixed proportions and input foreclosureeither would leave a single remaining unintegrated input supplier orwould allow multiple remaining suppliers to effectively coordinate prices,then low input cost share does lead to a higher percentage price increase.Moreover, the effect on downstream rivals overa ll costs actually is invari -ant to the input cost share. In general, because inelasti c demand facil i-tates pricing coordination, there i s no general reason to think that a lowinput cost share will reduce the likelihood of input foreclosure.

Even when the increase in the input price is constrained, enforcementmay still be warranted. For example, suppose that a vertical merger leadsto the price of spark plugs rising 50 percent by facilitating post-mergercoordinated pricing among the spark plug producers. including the up-stream divisi on of the integrated firm. Suppose the price of automobilesrises by the increased spark plug price only of (say) $25 per car on anoverall automobile price of $5.000. Antitr ust policy clearl y would not beIndeed. the plug monopolist actual ly would want to charge more than this because itignores the impact of the price increase on autom obile profits. as predicted by the theoryof the double markup.

See POSNER & EASTERBROO~. ru/,ra now 29. a, 336: Hay & Kellcy. r ,,pm note 53.a For example . suppose spark plug foreclosure raises rivals overall input costs from apremcrgcr level of $2,500 to a post.mcrger level of $3,500 . as spark p lug

Prices arc raisedfrom $25 to $1.025. If engines or iginal ly arc sold IO the manufacturers or Sl.000, then

en#ne f~rcc!osurc alw will lead engin e producers to raise their prices by $1,000 , implyin gan ndentlc al mcr~ase in rivals overall in put costs.

This rcsuk makes in tuitive sense. Supposc two inputs arc used in fixed proportions andone is supplied in a perfectly competitive market before and after the vcrdcal mergerinvolving rhc other. The market outcome should not depend on whether the one inputsupplier purchases the other compe dtively supplie d mput and packages it with its own orwhether the buyer purchases both inputs and dues the packaging. Yet the cost share ofthe foreclosed input wil l bc 100% in the first case and less than 100% in the second.

Even where th e rcsulling increase in rivalsovcrall costs (and, as a result, do wnstreamprices) is l?wer. there may still be a benef it to the intcgratcd firm. As discussed earlier, ioeffect. the mput foreclosure may facilitate pricing coordinarion amon g rhc input suppliersThe integrated firm lakes i ts profi ts in the downstream market and the unintegrated fim _.take their profits in the upstream market. 3

When the strict fixed p&po rtions assumptio n is relaxed. and a low cost share does placea greater limit on rivals overall cost increases. subsdtudon to other less cost.effecdvcalternadvc inputs acts as the constraint on the input price increase. If factual analysis were10 indicate that the pr ices of two different inputs with different shares of final output costwould rise by an equa l percentage with vertical integrat ion, the absolute price iocreasc(and the resul!ing incre?sc in rivals costs) would he larger for the more exp ensive input.For example . 11 competm on from dema nd substitutes prevents input price increases inCXC~S S of (say) 10%. then the maxim um input price increase for an in10 cents whereas the maxim um price increase ft,r an input Ihat costs

UI that costs $1 istl,OOO is SIOO.

19951 EVALUAT~NC VERTICAL MERGERS 545indifferent to a spark plug cartel that had equivalent price effects. Whyshould it countenance a vertica l merger that acts as a facilitating practicesimply because the price of automobiles will not rise by a large per-centage?

One difference is that the cartel i s a naked restraint whereas effectsfrom a vertica l merger are less predictable and the merger has potentialefficiency benefits. It would not make sense to sacrific e large efficiencybenefits to prevent a trivia l increase in riva ls costs and pri ces. Even thisis not so simple, however. The potential efficiency benefits li kely areproportionally smaller for inputs that represent a small cost share. Forexample, it is unlike ly that the acquisition of the spark plug producerwould reduce Fords ove rall costs as much as would the acquisition ofan engine plant. Thus, although consumer injury like ly is low. so arethe likely efficiency benefits. As a result, it is hard to see why enforcementshould be more permissive as a matter of policy rather than remainingdependent on factual analysi s of the actual balance.

g. Fixed Versus Variable Cost InputsCertain inputs are used on a fixed cost basis, that is, where usage of theinput does not vary with the amount of output produced. For example, amachine with no practical capacity constraint and a product certificationfrom a standard setting organization are fixed cost inputs. Other inputsare used on a variable cost basis, that is, where usage does vary with theamount of output produced. For example, raw materials, fuel, and labor

are variable cost inputs. It is a tenet of simple microeconomic modelsof profit-maximization that only variable (i.e., marginal) costs affect pric-ing in the short run. Fixed costs only affect pricing in the context oflong-run entry and exit.Input foreclosure involving variab le cost inputs translates directly into

increased variable costs. These higher variable costs place direct upwardpressure on riva ls output prices. The analysis of fixed-cost inputs i ssomewhat more complicated, depending on the time horizon of theanalysis.

Anal ysis of these factors determines the likelihood of anticompetitiveimpact i n the output market, absent efficiency benefits. T his analysisthen would be used in the evaluation of net competitive impact. Before

- -: . . -L . ^ _:^ __ _._1_. In the short run, increases in fixed costs will have no effccc on ~~nvaw P~ULC~ AFIIthey induce imme diate exit of soroe rivals or imme diately deter entry that otherwise wouldhave occurred. In the longer run. such fixed cost increases will have more effect on prices.They m ay deter entry by making entry less profitable . Where the fixed costs have not beensunk at prcmerger prices. increase, in fixed cow may induce exit by established firms.


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546 ANTITRUST LAW JOURNAL [Vol. 63

Figure 2. Input foreclosure impact on ancillary market

turning to that analysis, however, we analyze the potential for anticompe-titive effects in ancill ary markets.4. Step 3: Anficompct ifive Impacl in Ancillary Marketi

The third step evaluates impact on output prices in any ancill ary mar-kets or market segments. Anci llar y markets may be affected when pricediscriminati on in the input market is infeasible, as discussed earlier,Other ancil lary markets may be affected when there are demand orsupply side complementarities. Whatever the cause. the analysi s of ancil-lary markets focuses on the impact on consumers, competition fromrivals , and the impact on the profitabil ity of the integrated firm.

One possible ancilla ry market in the Ford-Autolite case arising frominabi lity to price discriminate is the aftermarket illustrated in Figure 2.As discussed earlier, when price discrimina tion is infeasible, a strategyof input foreclosure, if attempted, will lead to higher prices in ancill arymarket segments. For example, if Ford attempts to raise the costs of itscompetitors in the automobile manufacturing market by raising the price

of spark plugs, that strategy also would increase the price of sparkplugs in the aftermarket if price discrimination is infeasible. As a result,consumers of aftermarket spark plugs will be harmed.Other anc illary output markets also could arise for particular demandand supply side configurations. For example, suppose that the auto

EVALUATING VERTICAL MERGERSmanufacturers also produce another product. say electr ic golf carts, asa result of technological economies of scope, and that the golf cartsdo not utilize spark plugs. In this scenario, if Ford disadvantages itsautomotive rival s by raising their spa rk plug costs, they may also suffercost penalties in producing golf carts. In that case, Ford may also gainthe power to raise the price of golf carts, to the detriment of consumers.

Where potential price increases in ancill ary market segments occur,they also represent competitive harms from the merger, and thus shouldbe factored into the analysi s. In evaluating the magnitude and likelihoodof such harms, the general approach set out for Step I and Step 2 isfollowed. That approach involv es evaluation of the structure of theancill ary market, including abilit y of consumers to substitute to otherproducts. market shares, concentration and competition in the ancill arymarkets or market segments, ease of entry and expansion, and othercompetitive factors.

5. Step 4: Evaluation of Net Compelilivc ImpadHaving evaluated the potential impact of a vertical merger in the

various markets, it is necessary to describe the circumstances in which amerger should be deemed an ticompetitive under a structured rule ofreason analysis. As discussed earlie r, this involve s meeting a requiredthreshold to satisfy a standard of harm, absent any evidence of specificefficiency benefits. A s discussed earlier, it also involves meeting somestandard that governs the balancing of efficiency benefits against lik elymarket power harmssJ It should not be assumed that competitive harmsdominate efficiency benefits, or vice versa.

We envision the following decision-making sequence. Even before themerging parties are required to demonstrate any specifi c efficiency bene-fits, the complaining party (either the governmental enforcement agencyor a private litigant) must make a showing that the likelihood of competi-tive harms exceeds a threshold standard of harm. Onl y then would theissue of the proper balancing of efficiency benefits against potentialcompetitive harms become relevant.

We discus s the standard for finding competitive harm first. In analyz-ing input foreclosure, Step I evaluates the harm suffered by the riva lsforeclosed from the input market. Step 2 and Step 3 evaluate the harmto consumers who purchase the products sold in the output and ancilla rymarkets. This raises the issue of whether it is necessary to show thatoutput prices are like ly to rise in order to conclude that the verticalmerger is anticompetitive, or whether a finding of competitor injury


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548 ANTITRUST LAW JOURNAL [Vol. 63should be sufficient. For the reasons discussed below, we believe that ashowing of like ly consumer injury related to higher prices should benecessary to support the conclusion that a vertica l merger is anticompe-titive.by Arguably, a conclusion that exclusionary conduct in an input marketa vertic ally integrated firm is anticompetitive could rest solely on afinding that the rival s that are potential purchasers of the input areinjured by higher input prices or a refusal to deal.@ Injury to consumersresulting from higher prices is not strict ly necessary to demonstrate thatthe exclusionary conduct is profitable to the integrated firm. Even ifprices in the output market remain constant, diversion of sales to theintegrated firm would increase its profits if its price exceeds its marginalcost. Moreover, at least some consumer harm might occur i f consumerchoice in the output market is reduced by the exit or crippling of acompetitor, or a reduction in R&D, even if prices remain fully con-strained by competition from other firms.

In the antitrust analysi s of horizontal restraints, a showing of priceimpact in a final output market in which consumers purchase is notgenerally required for antitrust l iabil ity. For example, demonstratingharm from higher prices to the ultimate consumers who buy the productsmanufactured and sold by input purchasers clearl y would not be neces-sary in a price-fixing case. Similarly, in a horizontal merger case involv-ing inputs, proving solely that input prices wil l rise is sufficient. It is notnecessary also to demonstrate that the prices of products that utilize theinputs will rise. Instead, there essentia lly is an irrebuttable presumptionthat consumers will be harmed.

We think that this analogy to horizontal restraints, however, is insufti-cient to eliminate the need to show consumer injury from higher pricesfrom input foreclosure. First, vertica l mergers are entitled to a greater@ This is. for examp le. essentially the position taken by Timothy Brcnnan and Joseph

Bradley. See Timothy Brcnnan. Underr londing H&sing Rivolr Corb. 39 ANTITRUST BULL.95 (1988); Jose ph Bradley. Thr Econom ic GwLr o/ Anlirrtur: Ef jcitncy. Cotuunrr We&r, andTtrhnolo,$o, l Progress. 62 N.Y.U. L. REV. IO20 (19R7).

For cxamplc. in NCAA v. Board of Regents. 46X U.S. 85 (1984). the Court did notrequire analysis of the advertising market.

M This is a bit of an overstatement. In defining the relevant input market. the potenrialfor substitution by customers of the input purchasers is rclcvant. If that substkotion isstrong. lhcn the market may be define d more broadly, and as a rcsub. the merger mayfal l into the safe harbor region. See 1992 Horizontal Merger Guidel iner 8 9.1. supra note2% at 20.560 . Howcvcr. lhe fact that the downswcam price would not rise is not rufticicntto establ ish a broad market. For an example loc~cly bared on Aspen Skiing Co. v. AspenHighlands Ski ing Corp., 472 U.S. 51% (l9l lS). see Steven C. Salop. Eunlut ing N ~hvarkPncinRStlf .-R~~lnf inn. in ELECTRONIC Srvwcrs Nnwua~s: A BUSINESS AND PUSLK PoucuCHALLENCC ES. I10 11.20 (Margaret E. Go&-Calvcrt & Steven S. Wildman eds.. 1991).

EVALUATING VERTICAL MERGERSpresumption of cost savings and other efficiency benefits than are hori-zontal price restraints and horizontal mergers. Ve rtical mergers in volvefirms that normally have a contractual relationship to one another thatcontains cooperative elements. This is very different from the para-digmatic horizontal merger or horizontal price-fi xing matter.

Second, complaints about specific vertical mergers often are made bythe competitors of the merging parties. Those complaining competitorshave mixed motives. A lthough they are concerned about conduct thatharms consumers by raising riva ls costs, they also are concerned aboutconduct that benefits consumers by reducing the costs or improving theproducts sold by the merging parties. Either way, riva ls may be harmed.Because of the resulting potential for lawsuits attempting to enjoin merg-ers that benefit consumers, it may be necessary to require an explic itshowing of consumer injur y rather than relying on an irrebuttable pre-sumption.

Third, the magnitude of harm suffered by consumers solely fromelimination of choice and the resulting diversion of sales generally willbe quite lim ited in situations where the merger like ly will not increaseprices. If a reduction in consumer choice flowing from the exit or crip-pling of a competitor would have serious consumer welfare effects, onewould expect that the remaining nonexcluded firms likely would gain theability to raise their prices. Moreover, focusing solely on the reduction inchoice does not distinguish between acti ons that cause a rival to exitbecause the merged firm efficiently has succeeded in reducing its owncosts or improving its products and actions that destroy a rival by artifi-

evaluating vertical mergers complete)

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